Should I Consolidate My Debt?

Advantages + Risks of Debt Consolidation

By

Matt Lyons

on

Jan 21, 2021

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Looking for more ways to take care of your total debt? Debt consolidation could be the strategy that works for you! If you’re not familiar with the process, debt consolidation consists of combining multiple debts (like credit card bills) into one single payment. Paying off debts quickly can allow you to improve your credit score, and lower some of the interest rates you have on the loans. 

When to Consider Debt Consolidation

While debt consolidation may seem like a worthwhile idea, it is not a guaranteed means of success for everyone. If you don’t qualify for a lower interest rate, you won’t be able to reduce nearly enough debt. Characteristics that may qualify someone to succeed with debt consolidation include the following:

  • Your monthly debt payments (such as rent or mortgage) don’t exceed 50% of your total monthly gross income.
  • You can qualify for a credit card with a 0% interest period or low-interest debt consolidation loan if your credit is in good status.
  • You have enough monthly income that consistently covers the payments toward your debt.
  • You could pay off a consolidation loan within five years.

If you make your credit card payments on time resulting in good credit, you could qualify for a debt consolidation loan up to 10% lower than your current interest rate. You can also avoid some of the consequences that come with minimum payments by considering debt consolidation. Minimum payments can take years to pay off, and the interest rates just keep increasing. 

How Do I Consolidate My Debt?

There are two ways to go about debt consolidation. Both of these ways will include your debt payments in one bill each month. 

  • Get a balance-transfer credit card with 0% interest: This card can be used to transfer debts, where you will pay the full balance each month. If you have good credit, you will most likely qualify for this card.
  • Consider a fixed-rate debt consolidation loan: With this loan, you can use the money you receive to pay off your debts. After the debts are paid, you will pay back the loan over a set period of time. Those with the higher credit scores will qualify for the lowest interest rates. 
  • A personal or home equity loan is another good way to pay off your debt and save some more money on interest. You will get the most out of this if you are able to qualify for a bit lower of an interest rate.

Risks of Debt Consolidation

While Debt Consolidation is a great strategy for many, it’s not designed for everyone and there are some risks involved to consider.

Interest Rate Increase and Added Fees

Debt consolidation is typically best for those who are able to qualify for that low interest rate. However, many make the mistake of thinking that their credit score is strong enough to reach some of those more competitive rates. If you go through debt consolidation and your credit score isn’t where it’s supposed to be, you could end up paying even more than what you already are! This includes origination fees, balance transfer fees, annual fees, and closing costs. Before signing to a debt consolidation loan, you should make sure to understand all the costs beforehand. 

While your interest rate may initially go down when you have consolidated, you may be surprised to learn that you could actually end up paying more in interest over the new loan. Even though your monthly payments might decrease when debt is consolidated, the interest will still be added on continuously over time. To avoid an issue like this scenario, make sure that you work to budget for those monthly payments that are higher than the minimum. Reap the benefits of a debt consolidation loan without having to incur any additional interest!

Financial + Spending Issues 

While debt consolidation will help you to solve some of those major payments, you should work to address some of those previous habits that led you to the debts in the first place. No matter how effective the consolidation may have been, poor spending habits can cause you to continue racking up debt. 

Examples of good financial habits include:

  • Automate savings from your paycheck: Whether it be 10% or 5%, start saving some money from your paycheck in case of a financial emergency.
  • Save in small ways: Wash your clothes in cold water instead of hot water, use up the food you already have at your place, limit other spending like shopping to a certain period of time as a reward.
  • Look ahead at your goals: Good financial habits will set you up for success in the long term. While you’re doing your part and working to save money, you can reap the benefits later of vacations and even a happy retirement!

Paying off credit cards/lines of credit through debt consolidation can actually create the illusion for people that they have more money than they actually do. This can also result in those debts coming back to haunt you even if you think they’re gone for good. 

Types of Debt Consolidation Loans

The most common types of debt consolidation loans include personal and home equity loans.

Personal Loan

A personal loan, which is a form of a consolidation loan, is one of the most common types of a loan that can be offered from a bank, family member, or even friend. Usually personal loans don’t have very strict terms and conditions, so it may be easier to negotiate rates if you have a good credit score. 

Home Equity Loan

You can use home equity for debt consolidation if you owe less than your home’s market value, also referred to as home equity. Banks will allow you to borrow against up to 80% of the equity you have. For example, If you have $50,000 in equity you could borrow $40,000 to pay off your credit cards. You might be offering your home as a “collateral,” but at least you will be paying much less in interest!

Do some research and work on maintaining a good credit score before you sign on to a debt consolidation loan. While there are many potential benefits, there are always risks that should be taken into consideration!

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